According to the Walter’s Model, given by prof. James E. Walter, the dividends are relevant and have a bearing on the firm’s share prices. Also, the investment policy cannot be separated from the dividend policy since both are interlinked.
Walter’s Model shows the clear relationship between the return on investments or internal rate of return (r) and the cost of capital (K). The choice of an appropriate dividend policy affects the overall value of the firm. The efficiency of dividend policy can be shown through a relationship between returns and the cost.
- If r>K,the firm should retain the earnings because it possesses better investment opportunities and can gain more than what the shareholder can by re-investing. The firms with more returns than a cost are called the “Growth firms” and have a zero payout ratio.
- If r<K,the firm should pay all its earnings to the shareholders in the form of dividends, because they have better investment opportunities than a firm. Here the payout ratio is 100%.
- If r=K,the firm’s dividend policy has no effect on the firm’s value. Here the firm is indifferent towards how much is to be retained and how much is to be distributed among the shareholders. The payout ratio can vary from zero to 100%.
Assumptions of Walter’s Model
- All the financing is done through the retained earnings; no external financing is used.
- The rate of return (r) and the cost of capital (K) remain constant irrespective of any changes in the investments.
- All the earnings are either retained or distributed completely among the shareholders.
- The earnings per share (EPS) and Dividend per share (DPS) remains constant.
- The firm has a perpetual life.
Criticism of Walter’s Model
- It is assumed that the investment opportunities of the firm are financed through the retained earnings and no external financing such as debt, or equity is used. In such a case either the investment policy or the dividend policy or both will be below the standards.
- The Walter’s Model is only applicable to all equity firms. Also, it is assumed that the rate of return (r) is constant, but, however, it decreases with more investments.
- It is assumed that the cost of capital (K) remains constant, but, however, it is not realistic since it ignores the business risk of the firm, that has a direct impact on the firm’s value.
NOTE: The cost of capital (K) = Cost of equity (Ke), because no external source of financing is used.